Hanover profits from bad hurricane forecast

Sunday

Nov 24, 2013 at 6:00 AM

By Peter S. Cohan, WALL & MAIN

One of my favorite things to do is to make predictions about how things will turn out. When I am right, I tend to remind others. When I am wrong, I try to forget. Fortunately, my family tries to make me more humble emphasizing the times I was wrong and attributing my "prescient" guesses to luck.

This comes to mind in considering a dinner with my family at the beginning of September. That's when it occurred to me that the forecast for hurricanes this fall would turn out to be wildly exaggerated. That got me thinking about how investors could profit from that prediction. It turns out that I was right about the prediction, and wrong about how to profit from it.

While we had far fewer hurricanes than predicted and none that damaged the East Coast, I was thinking that the best way to profit from that would be to buy stock in catastrophe reinsurance companies — they insure big insurance companies against huge property/casualty losses — many of which are headquartered in Bermuda.

Stock in Worcester's Hanover Insurance Group — billing itself as "one of the top 25 property and casualty insurers in the United States providing property and casualty products and services to businesses, individuals, and families" — has done much better.

Before getting into what happened with the hurricane forecast this fall, I will try to explain the theory behind why I thought investing in catastrophe reinsurance companies would be a way to profit from a lighter-than-forecast 2013 hurricane season.

Insurance companies can often raise their prices after a major catastrophe that puts a strain on their capital. True, they have to go through a process of regulatory approval in the states where they operate. But if they can provide evidence that they have incurred above average claims for destroyed homes, cars and other property, the regulators usually let them raise rates.

This is what I thought must have happened after Hurricane Sandy hit in October 2012. I thought that as a result of all the damage done to the East Coast, people would have to pay much higher rates to insure their property in 2013. This would mean that the companies that sold them that insurance would get higher revenues.

Meanwhile, I thought, if it turned out that the hurricane season this fall turned out to be lighter than expected, the insurance companies would end up paying out less in claims. With higher revenues — resulting from boosted insurance rates — and lower costs from the lighter claims payments, the insurance companies would report higher profits in 2013 than they did in 2012.

The 2013 hurricane season was forecast to be highly active in the spring. According to a May 2013 report from the National Oceanic and Atmospheric Administration's Climate Prediction Center, during the season that officially begins in June and ends in November, there was a 70 percent likelihood of 13 to 20 named storms (winds of 39 mph or higher), of which seven to 11 could become hurricanes (winds of 74 mph or higher), including three to 6 major hurricanes (Category 3, 4 or 5; winds of 111 mph or higher).

These ranges were well above the seasonal average of 12 named storms, six hurricanes and three major hurricanes. In fact, as of mid-October 2013 there had been just 11 named storms, two of which were hurricanes, none that were major hurricanes —.just two short-lived Category 1 hurricanes in the Atlantic. None that made landfall in the U.S.

This is in sharp contrast to the 2012 season, during which there were 19 named Atlantic storms, 10 of which made hurricane status. This put 2012 in a tie for the third-most active hurricane season on record, despite pre-season predictions of a "near-normal" year. In all, the toll of the 2012 Atlantic hurricane season was 320 lives and an estimated $70 billion in damages, qualifying it for the second most expensive hurricane season on record, almost entirely due to Hurricane Sandy.

As a result of paying out those damages, property casualty insurance companies were able to raise the amount they charge their customers. Consider New Jersey, which suffered $6.3 billion in damages from Sandy, according to ISO Property Claims Service. Regulators there — fearing that insurers would leave the state — approved 50 percent more requests from insurers to raise homeowners' insurance premiums that have averaged more than 5 percent a year since 2010.

In short, insurance companies were able to raise rates in the wake of Sandy and in 2013 have paid out far fewer claims.

This leads to Hanover Insurance — it reported a 63 percent increase in net income for the first nine months of 2013 compared to 2012. In the third quarter of 2013, Hanover's boffo profit growth was due to a combination of higher revenues that grew around 5.5 percent in its business insurance lines — about the rate of premium increase in New Jersey — catastrophe losses that plunged 50 percent, and profits from investments.

Michael Buckley, Hanover's spokesman, said the company is pleased with its performance through the first nine months of the year. And weather played a part.

"Our results reflect the continued strong performance of each of our business segments — commercial lines, personal lines, and international specialty — which benefitted from better risk selection, mix and pricing. We also have benefitted from more favorable weather," he said. "Operating income for the first nine months of the year improved by approximately $80 million after taxes. More than half of that increase is the result of operating improvements. A little less than half of the improvement can be attributed to lower catastrophe losses. Putting weather aside, our operating results for the first nine months of this year were better than any over the past 10 years."

Hanover's stock has risen 71 percent in the last year and about 20 percent since the beginning of September when I made my lucky guess about the hurricane season.

I was thinking that a catastrophe reinsurer like XL Group would have been a good bet. But its stock is up only 29 percent in the last year and 3 percent since early September.